High dollar masking picture of inflation

The sky high New Zealand dollar is painting a flattering
picture of inflation.

Two things limit how much comfort the Reserve Bank, and
therefore borrowers, can draw from yesterday's pretty benign
consumers price index.

It knows that prices of non-tradable goods and services,
which are not influenced by international competition or the
exchange rate and make up about 56 per cent of the CPI, are
the main drivers of core or persistent inflation.

Non-tradables inflation, which reflects what is happening in
the inward-facing sectors of the economy where monetary
policy generally has more traction, has been rising pretty
relentlessly.

Though it softened a bit in the latest quarter, the annual
rate has averaged 2.9 per cent over the past four quarters,
up from 2.4 per cent over the previous four.

The other ground for discomfort at the central bank is that
it regards the kiwi dollar as unsustainably high, which
limits the extent to which it can expect a rising exchange
rate to keep a lid on prices of imported and exportable
goods, and the rate of tradables inflation accordingly low.

Tradables inflation was 0.1 per cent in the year to June
2014, the first time the annual rate has been positive since
March 2012.

The Bank for International Settlements calculates effective
(trade-weighted) exchange rates on both a nominal basis and
after adjusting for relative inflation rates. On both nominal
and real measures the New Zealand dollar has appreciated more
since 2010 than any other currency among the 27 it monitors.

The Reserve Bank in the forecasts it released last month
assumes that the kiwi dollar will fall gradually over the
next three years, by about 7 per cent on a trade-weighted
basis. No sign of that so far, though; in fact it has risen
nearly 3 per cent since then.

If there is a kind of arm wrestle going on between the two
big influences on the exchange rate - interest rate
differentials and commodity prices - the former seems to have
the brawnier biceps.

ANZ's index of export commodity prices fell for the fourth
month in a row in June, to 6.7 per cent below the peak
recorded in February. And that is before the latest drop in
dairy auction prices, to more than a third below their
February peak.

Combined with higher world oil prices that foreshadows a
decline in New Zealand's terms of trade, albeit from the most
favourable level in more than 40 years.

So far, though, the foreign exchange dealing rooms don't seem
to have got the memo, or at least are more focused on the
widening gap between New Zealand interest rates and those
prevailing in more sluggish economies.

We may have already seen the top of this cycle in terms of
quarterly growth rates but it adds up to a rate higher than
the 2.8 per cent the Reserve Bank reckons the economy can
sustain without bottlenecks emerging and inflation becoming
problematic.

There were some signs of emerging capacity constraints in
last week's quarterly survey of business opinion (QSBO) by
the New Zealand Institute of Economic Research.

Its measure of capacity utilisation rebounded to a level well
above the long-run average for this indicator. It reflects
the responses of manufacturers and builders when asked how
much is it practicable for them to raise production from
existing plant and equipment without raising unit costs.

Another indicator is how many firms in all sectors cite a
lack of capacity as the single factor most limiting their
ability to increase turnover. It has been rising steadily and
is now approaching the levels prevailing during the mid-2000s
boom.

The net balance of firms reporting that they have raised
their prices has been rising steadily to levels the institute
says point to an inflation rate around 2.5 per cent by the
end of the year.

"Price increases are expected to stabilise around these
levels," it said.

"The price increases are consistent with margin expansion as
costs have remained subdued." That is certainly true of wage
costs.

Always a cyclical laggard, the labour market right now is
marked by strong employment growth being matched by strong
growth in the supply of workers as fewer people leave for
Australia and more return.

The unemployment rate has been stuck at 6 per cent or
thereabouts since the middle of last year, well above any
plausible estimate of the rate at which it would put upward
pressure on inflation.

Statistics New Zealand's quarterly employment survey recorded
wage growth of 2.5 per cent over the year to March (average
hourly earnings across private and public sectors including
overtime).

That is 1 percentage point more than the inflation rate for
the same period, and it is up from 2.1 per cent a year
earlier, but down from 3.9 per cent a year before that. The
average rise in ordinary time wages and salaries in the
private sector alone was 2.9 per cent in the latest March
year, up from 2.3 per cent a year ago but down from 3.8 per
cent a year before that.

But again the QSBO detects some signs of incipient pressure.

The proportion of firms reporting that it is getting harder
to find the labour they need - both skilled and unskilled -
is rising.

And reported hiring is on a rising track, consistent with
annual employment growth of more than 3 per cent, the
institute says.

So as governor Graeme Wheeler surveys the world from high
above The Terrace, what does he see?

A currency which has proven exceptionally strong over the
past few years and which is defying gravity, relative to
falling export commodity prices.

For how much longer can he rely on that to offset rising
inflation in the domestic economy?

He sees an economy growing at a pace well above its
potential, or sustainable non-inflationary rate.

And he knows that changes he makes to the official cash rate
will take between one and two years to have their full
effects on output and then inflation.

About the only comfort he can take from yesterday's June
quarter inflation outcome is that it leaves the annual rate
at 1.6 per cent, far enough below the mid point of his target
band to give him some latitude for a pause, after next week's
OCR hike, to assess the effects of what he has done so far
and the implications of tumbling dairy prices.